Public Sector Governance and the Finance Sector
Dr Jeffrey Carmichael
Chairman, Carmichael Consulting Pty Ltd
Former Chairman, Australian Prudential Regulation Authority
Presentation delivered to:
A Regional Seminar on Non-Bank Financial Institutions Development
in African Countries
December 9-11, 2003, Mauritius
Sponsored by the World Bank
Public Sector Governance and the Finance Sector
1. Introduction
In recent years there has been a growing focus on corporate governance in
the finance sector reform programs sponsored by international organizations
such as the World Bank and the IMF.
I want to shift that focus to the less popular and considerably more sensitive
parallel need for international improvements in public sector governance.
I believe that, of the two, public sector governance is almost certainly the
more critical. The reason for this belief is that:

The size of the gains on offer are greater in the public sector, and

Improvements in corporate governance are unlikely to occur unless
they take place alongside public sector governance reforms.
There is a relatively new and creative literature emerging on this topic, mainly
out of the World Bank and Brookings Institution.
Most of this concentrates on corruption and its impact on economic growth
and welfare. This is very important - and I should add – courageous work.
However, I want to concentrate just on public sector governance in the
finance sector.
While this is a narrower focus, it is made more complicated by the fact that
there are many legitimate roles for the public sector in the finance sector.
Consequently, poor public sector governance has aspects that extend well
beyond the effects of corruption.
2. Outline
This is a very broad topic and I will just focus on a few key areas:

First, I want to define public sector governance and look at where the
problem comes from;

Second, I want to look briefly at areas in which public sector
governance problems arise and the costs that can follow from poor
governance; and

Third, I want to offer some thoughts on how to go about addressing
just a few of the public sector governance problems.
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3. Definition of Public Sector Governance
There is not yet any universally agreed definition of public sector governance.
My preferred definition is:
“The systems and processes by which a company or government
manages its affairs with the objective of maximizing the welfare of and
resolving the conflicts of interest among its stakeholders.”
In essence, governance is about the way in which a company or Government
proposes to reconcile the conflicting interests of its various stakeholders and
the structures it puts in place to ensure that these objectives are met; that is,
it encompasses both policy and practice.
Fundamentally, good governance is about resolving conflicts of interest.
At the heart of the conflict problem is agency costs – those conflicts and costs
that arise when the principal in any operation or transaction appoints an agent
to look after his/her interests. The problem is that:
•
When I act for myself as a principal, I know exactly whose interests I
am pursuing;
•
Delegation, however, implies a loss of control and the possibility that
my agent will pursue his own interests instead of mine;
•
Solutions to the agency problem that arises in corporate situations
focus mainly on inappropriate incentives – that is, how can the principal
write a contract with appropriate incentives for the agent to pursue
courses of action that coincide with the principal’s best interests.
•
The public sector agency problem has some of the same elements.
But, more important, and often overlooked, is that principal/agent
agreements in the public sector often lack clarity – in short, the problem
in the public sector is often that the principal fails to specify with
sufficient clarity what interests are to be pursued and how the agent is
supposed to achieve them. This is a point I will come back to when I
look at some solutions.
4.
Areas in which Public Sector Governance Problems can arise
Before I do that, let me look briefly at areas in which public sector governance
problems can arise in the finance sector and why good public sector
governance is so critical.
The public sector participates in the finance sector of most economies to an
extent and in ways that are quite unlike its role in other sectors of the
economy. This participation typically includes some or all of the following:

As the regulator of financial institutions;
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
As an owner of financial institutions (banks and insurance are common
– creates implicit guarantee plus possible access to information and
opportunities for corruption);

As a market participant (e.g. governments issue debt and trade in it –
access to information);

As a fiduciary agent (through pension schemes in particular – access
to funds for corruption and political purposes); and

Through direct intervention in the operations of the market (guarantees,
direct support and directed lending).
Each of these involves principal/agent problems and conflicts of interest
between the public sector, its agents and the public.
It is important to identify who the principals and agents are in some of these
situations. In many cases there are several levels of principal and agent.
For example, in the case of regulation, the ultimate principals are the public,
who benefit from good regulation and who suffer when regulation falls short.
The public delegate their interests to the government as their agent. The
government in turn typically delegates the responsibility for regulation to a
regulatory authority. Within the regulatory authority there may be multiple
levels of delegation. For example, from a board to senior management and
from senior management to staff. That creates four or more levels of
principal/agent delegation and therefore multiple levels at which governance
issues can arise.
Let’s look now at why good governance so important in the public sector
context.
While the underlying principles are the same as in corporate governance, the
problems are more complex, more difficult to resolve, and the costs of poor
governance are potentially much greater than those of poor corporate
governance.
The first level of complexity relates to the difficulty of measuring, and therefore
monitoring, the principal/agent problem. Unlike the corporate sector, there is
no simple metric such as profitability by which to measure the performance of
the public sector.
This also applies to measuring the costs of poor governance. For example,
how do you measure the opportunity cost, in terms of foregone production
and human suffering, of poor advice from a Department of Finance that leads
to recession, or of an under-resourced regulatory agency that fails to prevent
an impending financial crisis.
There is therefore an inherently low level of transparency about the public
sector.
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Second, unlike the situation facing corporate shareholders, there is no
‘market’ for principals who wish to exit their exposures to the public sector.
Unlike shareholders, citizens cannot ‘sell’ their vote, other than at election
time. Like minority shareholders, they have little leverage, other than at
election time, to force the government to alter its behaviour.
Third, governments and their bureaucracies possess temporary monopoly
power. For example:

The department responsible for issuing import licenses, for example,
does not do so in competition with other departments;

With the exception of the US, financial regulators usually have a
monopoly over their particular area;

The immigration clerk issuing entry visas or work permits has an
unequal bargaining position relative to the applicants.
The main effect of this temporary monopoly power is the opportunity it creates
for corruption.
However, while corruption is arguably the main manifestation of poor public
sector governance, it is by no means the only one. The importance of this
distinction is more apparent in the finance sector than in other sectors of the
economy due to the pervasiveness of the public sector in finance.
In looking at the costs, let me start with corruption.
There has been some very good work done on measuring corruption and its
impact on the economy. The main conclusions of this research are
surprisingly robust:

Corruption reduces domestic investment

Corruption reduces foreign direct investment

Corruption reduces economic growth

Corruption reduces government revenue, increases the size of
government expenditure and tends to bias it away from operations,
maintenance and social infrastructure such as health and education, in
favor of new equipment and physical infrastructure.

Corruption reduces the effectiveness of financial regulation and leaves
the system more vulnerable to currency crises.

Corruption tends to increase the size of the underground economy.
The most striking features of this growing research are the sizes of the
estimated impacts of corruption and the extent to which they carry social as
well as economic implications.
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While corruption is a major source of cost, it is by no means the only one that
arises in the finance sector from poor public sector governance.
Even without the explicit motive of personal gain, government involvement,
without adequate rules to govern that involvement, can impose substantial
costs on the community. Some of the more important of these are:

First - Poorly-designed financial regulation can expose the financial
system to crisis and collapse. The biggest impact here comes from
poor transparency regulation.

Second - Where publicly-owned financial institutions are not subject to
the same prudential and conduct regulation as private sector firms,
competition can be distorted, innovation can be retarded, and signs of
financial distress in the public institutions are likely to be disguised until
the problem becomes a crisis.

Third - Attempts to reform regulation and governance among private
sector financial institutions are likely to fail unless publiclyowned/managed financial institutions are subject to rules of behaviour
at least as stringent as those imposed on private firms.

Fourth - A lack of transparency in public sector fiduciary relationships
can be a source of long-term financial hardship and disappointed
expectations.

Fifth - Since the attitude of the public sector with respect to its own
market conduct conveys an important signal to private sector market
participants, the way in which it handles conflicts of interest, privileged
information and disclosure will have an important bearing on the
integrity of private sector financial markets.

Sixth - Government intervention in financial markets carries a
significant element of moral hazard. This has been borne out again
and again by countries that have stepped into crises with public sector
guarantees of deposits and other financial claims. These have a way
of escalating the size of the problem as unscrupulous operators take
advantage of the guarantees or support to send good money after bad.
5.
Addressing Public Sector Governance in the Finance Sector
So how do we address the public sector governance problem? I believe there
are five main elements to the solution:

First there is a need to agree a framework for assessing the
appropriate role of the public sector in the financial system;

Second, where participation extends beyond the appropriate roles,
devise a process for winding back that involvement;
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
Third, establish a set of Public Sector Governance Principles to apply
to the legitimate, on-going participation of the public sector in the
financial system; and

Fourth, where the gap between the ultimate objective and the starting
point are too great, identify some practical steps to begin the process.

Fifth, we need to provide some practical guidance on how to implement
good governance.
Given my limited time I want to comment briefly on just a couple of these
issues.
The first issue I want to comment on is the need for some internationally
agreed principles of public sector governance. Important components of such
a set of Principles are already contained in the IMF Code of Good Practices
on Fiscal, Monetary and Financial Policies.
These Principles, however, need to be extended and modified slightly to cover
regulation and public sector ownership – particularly in the following areas:

Transparency and Accountability of regulators and Publicly-owned
enterprises;

Independence of Financial Regulatory Agencies; and

Anti-Corruption Measures.
The first of these is a fairly easy extension of the IMF Code.
The second requires Governments to face up to some simple realities. Since
many Governments participate in the financial sector as both an owner and a
market participant, good governance demands that regulatory agencies have
a high degree of independence or autonomy from the Government. It also
demands that Government-owned financial institutions be subjected to the
same regulatory standards as their private sector competitors. Too many
Governments are content to allow their own public sector institutions to enjoy
a market advantage from soft regulation – and then look for scapegoats when
these institutions fail.
The third missing element of the Principles is the need for anti-corruption
measures. The existing IMF principles for Monetary and Fiscal policy focus a
lot on disclosure and transparency of Government agencies. Corruption
thrives on secrecy. Therefore, any measures that improve disclosure and
accountability are natural opponents of corruption. So too are measures that
that provide regulators with legal protections against capricious removal from
office and also against prosecution for doing their jobs in good faith.
The other area I want to comment on is the need for practical guidance on
implementing principles of good governance.
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Let me give an illustration of what I mean. I mentioned earlier the need for
clarity in directions from principals to agents. A key component of the
principal/agent problem is that it involves delegation. How then can we
establish an approach to delegation that provides clarity?
I recently went through a review session with the Board of the Mauritian FSC
in which we developed such an approach for delegations from the Board to
Senior Management. The essence of that approach was the following. First,
the Board members agreed that as a non-executive Board they could not be
hands on with ever issue – Boards cannot micro-manage. Following from
that, the Board agreed they needed a process for deciding when to be hands
on and when to be hands off. That meant they needed to:

Prioritize Board involvement;

Give clear directions to Management as to how they were to exercise
their delegations where the Board decided to be hands off; and

Establish an accountability process to satisfy the Board that their
directions were being observed.
In order to prioritise Board involvement we started by breaking the agency’s
responsibilities down into a series of functions and activities, such as
formulating policy, formulating procedures, enforcement, administration, and
so on. Some of these could be delegated and some could not. For example,
the Board agreed that it could not reasonably delegate responsibility for
formulating policy, whereas it could delegate responsibility for the day-to-day
administration of the agency. In a sense they created a scale of “hands onness” for these functions and activities.
For each of these functions they established an appropriate set of
responsibilities for the Board and for Management. For example, the Board
may be responsible in a given area for establishing policy, while Management
may be responsible for putting the details on the policy and for implementing
it.
The final stage of the process was to create a formal written delegation
document that spelled out clearly the objectives of the function, the roles and
responsibilities of the different parties, how Management were to carry out
their delegated responsibilities, and finally how Management were to account
to the Board for the exercise of their delegated responsibilities.
By working through each area and function of the agency, the Board would
then establish a comprehensive delegation framework.
I think I can say, without casting dispersions on my fellow regulators, there
would be very few regulatory agencies in the world that could claim to have
such a comprehensive framework.
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Closing Comments
By way of closing, let me say that strengthening public sector governance is
possibly one of the greatest challenges we face internationally. Without good
public sector governance, financial markets are unlikely to operate efficiently
or effectively, corruption is likely to retard economic growth and welfare, and
efforts to reform private sector performance, through regulatory reform,
corporate governance reform and anti-corruption measures, are largely
doomed to failure.
The stakes are high and there is a need to put much greater efforts into public
sector governance in coming years. This is an issue for both emerging and
developed markets. But the urgency for emerging markets is much greater
because of the risk otherwise of being left behind in the global world without
the capacity to benefit fully from the developments taking place around you
and with an ever increasing vulnerability to crisis.
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